MF Global : 99 Problems And Auditor PwC Warned About None

Francine McKenna
, ContributorI cover the accounting industry and accounting issues for investors.Opinions expressed by Forbes Contributors are their own.

November 2, 2011

There are some great wrap ups today in all the major media. Fortunately, none of them touch on the issues I will for Friday's American Banker column. One that comes close is a Thomson Reuters column by Alison Frankel on the potential for litigation against PwC.

Alison's conclusion - Likely but not likely to be successful. Sadly, I have to agree, although there are ways of "making them talk."

As revelations emerged Tuesday about alleged accounting shenanigans at the bankrupt brokerage MF Global -- which reportedly commingled its own money with customer accounts -- auditor watchdog Francine McKenna posted a terrific piece at Forbes called "99 Problems and Auditor PwC Warned about None." As MF Global's auditor, McKenna reported, PricewaterhouseCoopers gave the brokerage a clean report as recently as May (and apparently billed MF Global $12 million for its services over the last year). Angry MF Global investors are probably wondering whether they can load any of the blame for the brokerage's downfall on PricewaterhouseCoopers.

The answer, according to a prominent plaintiffs' lawyer I talked to Tuesday, is almost surely no, at least in terms of tagging the auditor with liability for MF Global's losses...

The New York Times takes this opportunity to recap Corzine's biography. Because it's all about him. As my friend John Needham here in Chicago said yesterday:

"If Corzine were a low level "rogue trader" like SocGen's Kerviel or UBS' Adoboli he'd be in jail already."

The fallout from MF Global Holdings Ltd.'s collapse intensified as the Commodity Futures Trading Commission voted to issue subpoenas to the securities firm and the Federal Bureau of Investigation planned to examine whether client funds are missing, according to people familiar with the situation...

November 1, Noon CST: The regulators are stepping up their activity.

SEC and CFTC put out a joint statement:

SEC-CFTC Statement on MF Global
11/01/2011 09:30 AM EDT

FOR IMMEDIATE RELEASE 2011-230 Washington, D.C., Oct. 31, 2011 - The Securities and Exchange Commission and Commodity Futures Trading Commission today made the following joint statement: "For several days, the SEC, CFTC and other regulators had been closely monitoring developments affecting MF Global, Inc., a jointly registered futures commission merchant and broker-dealer, in anticipation of a transaction that would include the transfer of customer accounts to another firm. Early this morning, MF Global informed the regulators that the transaction had not been agreed to and reported possible deficiencies in customer futures segregated accounts held at the firm. The SEC and CFTC have determined that a SIPC-led bankruptcy proceeding would be the safest and most prudent course of action to protect customer accounts and assets. SIPC announced today that it is initiating the liquidation of MF Global under the Securities Investor Protection Act (SIPA)."

The CME's Craig Donahue confirms during their earnings call that there definitely is a problem with customer funds segregation. But CME Group is not going to be the one to come up with the cash so traders can get back in the pit or on the screen.

“MF Global is not in compliance with CME and CFTC regulations related to customer segregation” of funds, Craig Donohue, CME Group’s chief executive officer, said on a conference call today with analysts. The exchange is working with the CFTC to determine the extent of the problem, he said.

Singapore Exchange (SGX) said in a separate statement that the appointment of KPMG does not affect the transfer of customers' derivatives positions on SGX from MF Global to other clearing members.

Yeah, that's still "in process". Some MF Global "risk managers" are calling their customers and trying to shop groups of accounts to new clearing firms. That's a good move on their part in this "every man for themselves" environment, but be sure your guy has the authority to do that now that a bankruptcy trustee is involved.

Yes, a bankruptcy trustee has finally been assigned. It's the same one that worked on the Lehman liquidation. Given what the UK regulators found out about audit firms Ernst & Young and PwC enabling commingling of funds by Lehman and JP Morgan during the crisis, that move does not bode well on that front. But Giddens certainly has the experience. There's a preliminary hearing scheduled for later today.

Oh no they didn't... Please tell me they didn't... Update, The New York Times, 9:55 pm Monday:

Federal regulators have discovered that hundreds of millions of dollars in customer money has gone missing from MF Global in recent days, prompting an investigation into the brokerage firm, which is run by Jon S. Corzine, the former New Jersey governor, several people briefed on the matter said on Monday.

The recognition that money was missing scuttled at the 11th hour an agreement to sell a major part of MF Global to a rival brokerage firm. MF Global had staked its survival on completing the deal. Instead, the New York-based firm filed for bankruptcy on Monday.

Regulators are examining whether MF Global diverted some customer funds to support its own trades as the firm teetered on the brink of collapse.

The discovery that money could not be located might simply reflect sloppy internal controls at MF Global. It is still unclear where the money went.

Don't say I didn't warn you.

No one liked what happened to MF Global traders and customers Monday morning as we waited for an announcement of MF Global's fate. There were rumors of a bankruptcy but there was still hope something would happen. When news to the bankruptcy filing came, as a result of the deal with Interactive Brokers falling through late Sunday night, at least we had an answer.

But then suddenly I received reports of trading accounts accounts being frozen on the floor of the CBOT/CME in Chicago with no warning. Whether you were an MF Global employee or a broker or trader who cleared with them, you were suddenly unable to enter trades on the screen when that window had been open just minute before. Leaving that window open Monday morning caused many to enter trades that are now in limbo unable to be unwound.

Then there were conflicting reports about how those with collateral on deposit would be able to get their funds transferred to another clearing firm so they could trade or execute trades again. The CME put out a confusing message - one that caused some to start panicking. In retrospect I should have taken those concerns more seriously.

CME clearing will process any transfers at the last settlement price at the request of customers. Such positions will need to be re-margined at transferee firm.

If all the money was there, why would you have to re-margin the positions? Where and when would the orderly transfer occur?

I also received a tip that some major players may have gotten their money out last week, ahead of the pack. That's called "fraudulent conveyance". If these most favored firms funds were in the unsegregated category, based on the products or services they used MF Global for, and their withdrawals based on a friendly tip hampered MF Global's ability to meet their own margin calls, that may explain why MF Global may have dipped into segregated funds. But that does not excuse the inexcusable.

Unfortunately this is not the first time that PwC, MF Global's audit firm, did not monitor a client's controls over segregated funds well.

Auditor PricewaterhouseCoopers admitted to years of mistakes relating to the failure of investment bank JP Morgan to ensure that billions of pounds of its clients' assets had been properly ring-fenced.

PwC is now expected to face a heavy fine over its role in the client asset scandal which could have wrought unnecessary mayhem had the bank collapsed at the height of the financial crisis in October 2008. At that point, JP Morgan's futures and options desk held $23bn (£14bn) of client money, largely belonging to hedge funds, which was not segregated from the bank's own funds.

Pre-market trading in MF Global Holdings has been halted since about 6 a.m. ET as news is expected to be released about Jon Corzine’s ailing brokerage...

The Wall Street Journal reported Sunday night that MF Global is working on a deal to push its holding company into bankruptcy protection as soon as Monday, and to sell its assets to Interactive Brokers Group in a court-supervised auction.

Some excerpts from the recent MF global debt issue that I tweeted yesterday.

You may recall the last time I wrote about MF Global. That story was about the "rogue" trader that cost them $141 million. In the meantime we've seen another "rogue" trader scandal and PwC has given MF Global clean opinions on their financial statements and internal controls over financial reporting since the firm went public in mid-2007.

J.C. Flowers is one of several firms considering an acquisition of part or all of MF Global, which is trying to deal with an outflow of customer money and has seen its stock decline 67% since last Friday.

The people described the talks between J.C. Flowers and MF Global as serious but not exclusive. They cautioned a deal may not happen.

MF Global and its chief executive Jon Corzine have close ties to J.C. Flowers. J.C. Flowers already owns a 6% stake in MF Global, held in preferred shares. It gained its position in 2008 when it stepped in to help support MF Global three months after the firm sustained a $141 million charge from unauthorized wheat trades.

I'm sure PwC thought everything was peachy as recently as this past May when the annual report came out for their year end March 30. Instead we're seeing another sudden, unexpected, calamitous, black-swan event that no one could have predicted let alone warn investors about.

Right....

According to the latest proxy, MF Global spent almost $12 million on total fees to PwC last year. That's pretty paltry for a firm with the issues and complexity MF Global has. Tax fees paid says it includes amounts for "tax return preparation" which is commonly avoided post Sarbanes-Oxley. The auditor can not audit deferred tax amounts and tax loss carry forwards that were determined when their own firm prepared the returns. The client MUST prepare their own FAS 109 calculation and the auditor only reviews it.

Also included in the total fees amount is $558 thousand in "Other" fees that are not explained in the proxy and are more than twice as high as amounts spent the prior year in this category. Were these amounts spent on services prohibited by Sarbanes-Oxley like internal audit or systems implementation?

PwC likely doesn't want to be the straw that broke the camel's back with a "going concern" qualification. A non-qualified audit opinion is typically a requirement of credit lines and debt issues. After all, why alienate potential clients when you can let the ratings agencies do it for you. The downgrades to junk by Moody's and Fitch will likely precipitate their most recent debt issue being called because of a breach of covenants.